Policymakers blame the undervalued RMB for the global imbalances. Here one of the world’s leading development economists argues that the undervalued currency boosts China’s growth, and this, in turn, is good for the world’s recovery and the alleviation of poverty. China could maintain its growth without trade imbalances if it could introduce industrial subsidies to offset a rising yuan. It is better to subsidise tradables directly than to subsidise them indirectly through the exchange rate. This may run afoul of WTO rules, but that doesn’t diminish the economic case for the policy.

As it comes out of the crisis, the world economy faces two apparently conflicting demands. On the one hand, achieving global macroeconomic stability and preventing a protectionist backlash will require that we avoid large current account imbalances of the type that the world economy experienced in the run-up to the crisis. On the other hand, returning to rapid growth in the developing nations will require that they resume their conquest of global market share in tradable goods.

The challenge of meeting both demands is epitomised by the contentious US-China bilateral relationship. American (and European) policy makers blame China for an undervalued renminbi, which they argue is the root cause of China’s huge trade surplus (Cline and Williamson 2009). Chinese leaders resist the pressure, fearing that appreciation will undercut the competitiveness of Chinese goods in world markets, hurt exports, and damage growth. China’s arguments are typically dismissed by Western commentators, who argue that it is time the country turned away from exports and gave a boost to its service industries.

But if growth depends primarily on the supply of modern manufactured products and other tradables as opposed to services and non-tradables, as I think it does, the Chinese position has more force than critics give it credit. The conventional fix for China’s current account surplus, consisting of a combination of expenditure expansion and currency appreciation, will shift the structure of the economy away from tradables and towards non-tradables. This may be good for macroeconomic balance in China and elsewhere, but it will almost certainly have adverse effects on China’s growth – perhaps large enough to even endanger the country’s social and political stability.

Tradables as the engine of growth

What is common in the experiences of Japan, South Korea, China, and all other growth superstars? They all based their growth strategies on developing industrial capabilities rather than on specialising according to their prevailing comparative advantages. They each became manufacturing superpowers in short order – and much more rapidly than one would have expected based on their resource endowments. China’s export bundle was built up using strategic public investments and industrial policies that forced foreign companies to transfer technology; today, the country’s export bundle resembles what one would expect for a country that is three or four times richer than China.

High-growth countries are those that are able to undertake rapid structural transformation from low-productivity (“traditional”) to high-productivity (“modern”) activities. These modern activities are largely tradable products, and within tradables, they are mostly industrial ones (although tradable services are clearly becoming important as well). Figure 1 shows the tight association between industrial employment and growth, over time within countries.

Figure 1. Partial correlation between employment share of industry and growth, 5-year panels controlling for initial income and country and time fixed effects

Why is transition into modern industrial activities an engine of economic growth?

As I discuss in Rodrik (2008) and in line with a long tradition of dual-economy models, the answer is that there exist significant gaps between the social marginal productivities in traditional and modern parts of developing economies. Even very poor economies have economic activities – horticulture in Ethiopia, auto assembly in India, consumer electronics in China – where productivity levels are not too far off from what we observe in the advanced economies. As resources move from traditional activities towards these, economy-wide productivity increases.

These gaps can be due to a wide range of features that are specific to under-development. I discuss two broad categories in Rodrik (2008b). One has to do with institutional weaknesses – such as poor protection of property rights and weak contract enforcement – which make themselves felt more intensively in tradable activities. The second relates to various market failures and externalities – e.g., learning spillovers and coordination failures – associated with modern activities. In both cases, industrial activity and investment are underprovided in market equilibrium. Anything that speeds up structural transformation in their direction will speed up the rate of economic growth.

The reason that undervaluation of the currency works as a powerful force for economic growth is that it acts as a kind of industrial policy. By raising the domestic relative price of tradable economic activities, it increases the profitability of such activities, and spurs capacity and employment generation in the modern industrial sectors that are key to growth. As discussed in detail in Rodrik (2008), the association between undervalued currencies and high growth is a very robust feature of the post-war data, particularly for lower-income countries.

China’s currency undervaluation

China has not always had a large external imbalance, or an undervalued currency. In fact, prior to the present decade it never had a current account surplus exceeding 4% of GDP. From 2001 on, China’s surplus began its inexorable rise to more than 10% by 2007. The index of undervaluation I used in Rodrik (2008) similarly bottoms out in 2001 and increases thereafter (Figure 2).

Interestingly, 2001 also saw China joining the WTO, after years of negotiation. It may not be a coincidence that China’s current account imbalance began to widen and its currency undervaluation started to rise just as the country became a member of the trade body. WTO membership made it difficult, if not impossible, for China to promote its industries with the type of explicit industrial policies that the country had been relying on. Prior to the late 1990s, China’s manufacturing industries were promoted by a wide variety of inducements, including high tariff barriers, investment incentives, export subsidies, and domestic content requirements on foreign firms. As a condition of membership, China had to phase out these policies. From levels that were among the highest in the world as late as the early 1990s China’s import tariffs fell to single-digit levels by the end of the decade. Local content requirements and export subsidies were eliminated. Currency undervaluation, or protection through the exchange rate, became the de facto substitute.

What if China stopped growing?

If undervaluation has supported China’s recent growth, what kind of growth penalty would the economy suffer if China were to let its currency appreciate (in the absence of compensating changes in industrial policies)? In Rodrik (2008), I report panel regressions which suggest that the partial correlation between my index of (log) undervaluation and annual growth rate is 0.026 for developing nations. (For reasons explained in that paper, I am inclined to think of this relationship as causal.) However, in the case of China this estimate rises to 0.086, a much bigger number that may be due to the large reservoir of surplus labour and the huge gap in the productivity levels of modern and traditional parts of the economy (Figure 3). This estimate implies that a 10% appreciation would reduce China’s growth by 0.86 percentage points.

Figure 3. The relationship between undervaluation and economic growth among all developing countries and in China.

Note: See Rodrik (2008) for details of the estimation.

By many accounts, including my own estimates (based on price-level comparisons with adjustments for Balassa-Samuelson effects), China’s currency is undervalued by around 25%. Correcting this undervaluation would result in a reduction in Chinese growth of 2.15 percentage points per annum (=0.25x0.086). This is a sizable effect, even by the standards of China’s superlative growth record. Most importantly, a slowdown of this magnitude would put China below the 8% growth threshold its leadership apparently believes is necessary to maintain social peace and avert social strife.

No-one knows where the 8% figure really comes from; it clearly does not have a scientific basis. Many China experts think the Chinese society and polity are capable of handling growth much lower than that. Nevertheless, even if the political implications can be put aside, it would be hardly a desirable outcome if the most potent poverty-reduction engine the world has ever known were to experience a noticeable slow down. It is true that other countries that relied on exports to grow rapidly – such as Germany, Japan, and South Korea – eventually had to let their currencies appreciate. But China is still a very poor country, at barely above one-tenth the income level of the US. It has a huge reservoir of surplus labour in the countryside. In addition, it has to live with restrictions on its industrial policies that none of these other countries, in pre-WTO days, had to abide by.

Channels linking undervaluation and growth

The real exchange rate affects the trade balance, the supply of exports, and the production of tradables. Which of these is the channel through which an undervaluation spurs growth? In Rodrik (2009) I ran a series of horse races between these contending mechanisms. I found that industrial activity dominates both exports and the trade surplus. In particular, when industry and export shares are included together, both are statistically significant, but the estimated impact of industrial activity is more than twice as strong. A one standard-deviation increase in industrial shares is estimated to increase growth by 1.6 percentage points, while the corresponding increase in export shares boosts growth only by 0.7 percentage points. Moreover, it turns out that the result with export shares is not robust.

The implication for China and developing nations that have gotten hooked on trade surpluses or exports as their “engines of growth” is clear. What really matters is the output of tradables (proxied in my statistical exercise by industrial production). Neither exports nor trade surpluses are key – as long as domestic demand for tradables can be increased alongside the domestic supply.

Structural change and growth without trade surpluses

The good news therefore is that there is no inherent conflict between China’s growth and other countries’ desire to have reasonably balanced external accounts. What matters for growth in developing nations like China is not the size of their trade surplus, nor even the volume of their exports. What matters for growth is their output of non-traditional tradables, which can expand without limit as long as domestic demand (for those same goods) expands at the same time.

So there is a simple solution. It is possible to let the renminbi appreciate, and hence eliminate the trade surplus, as long as complementary policies are put in place to support modern tradables more directly. Such policies, combined with macroeconomic policies targeted at the current account, can achieve both external balance and structural change in favour of modern tradables. It is better to subsidise tradables directly than to subsidise them indirectly through the exchange rate which also happens to tax the domestic consumption of tradables.

Such subsidies may well run afoul of WTO rules. But that doesn’t diminish the economic case for them.

Comments

The above argument ignores the immediate rise in real wages for those in non-manufacture and non-tradable activities that comes from a revaluation. To illustrate, revalue the currency, and ten million Chinese peasant farmers will immediately be able to afford that TV set or PC that they previously couldn’t.

Whether they buy the latter goodies from local Chinese manufacturers or import them doesn’t matter. The point is that revaluation increases the power of Chinese consumers to purchase whatever they want from around the world. And that equals real economic growth.